chapter 001 goals and governance of the firmtestbankcollege.eu/sample/...of-corporate-finance-6th...

Full file at http://TestbankCollege.eu/Test-Bank-Fundamentals-of-Corporate-Finance-6th-Edition-Brealey

True / False Questions

1. The liability of sole proprietors is limited to the amount of their investment in the company. FALSE

AACSB: Communication AbilitiesBloom's: KnowledgeDifficulty: EasyLearning Objective: 1-3

2. General partners have limited personal liability for business debts in a limited partnership. FALSE

AACSB: Communication AbilitiesBloom's: KnowledgeDifficulty: MediumLearning Objective: 1-3

3. The separation of ownership and management is one distinctive feature of corporations. TRUE

AACSB: Reflective Thinking SkillsBloom's: UnderstandingDifficulty: EasyLearning Objective: 1-3

4. A major disadvantage of partnerships is that they have "double taxation" of profits. FALSE


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5. Financial assets have value because they are claims on the firm's real assets and the cash that those assets will produce. TRUE


6. Capital budgeting decisions are used to determine how to raise the cash necessary for investments. FALSE

AACSB: Reflective Thinking SkillsBloom's: UnderstandingDifficulty: MediumLearning Objective: 1-1

7. A successful investment is one that increases the value of the firm. TRUE


8. BP's committing of $500 million to partnership with University of California–Berkeley to develop new sources of energy is a capital budgeting decision. TRUE

AACSB: Reflective Thinking SkillsBloom's: ApplicationDifficulty: EasyLearning Objective: 1-1

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9. Boards of directors are often portrayed as active supporters of top management. FALSE


10. Financial analysts are involved in monitoring and controlling the risk associated with investment projects and financing decisions. TRUE


11. The primary goal of any company should be to maximize current period profit. FALSE


12. Maximizing profits is the same as maximizing the value of the firm. FALSE


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13. Major banks and securities firms protect their reputations by emphasizing their long history and their responsible behavior when seeking new customers. TRUE

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: UnderstandingDifficulty: EasyLearning Objective: 1-6

14. Ethical decision making in business can be viewed as a long-term investment in reputation. TRUE

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: UnderstandingDifficulty: EasyLearning Objective: 1-6

15. Real assets can be intangible assets. TRUE


16. Making good investment and financing decisions is the chief task of the financial manager. TRUE


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17. If a project's value is less than its required investment, then the project is attractive financially. FALSE


18. Pfizer's spending of $7.6 billion in 2006 on research and development of new drugs is a capital budgeting decision but not a financing decision. TRUE

AACSB: Reflective Thinking SkillsBloom's: ApplicationDifficulty: MediumLearning Objective: 1-1

19. LVMH's Issuance of a 7-year bond in 2005, raising 600 million euros is a financing decision. TRUE


20. An IOU ("I owe you") from your brother in law is a financial asset. TRUE


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21. The separation of ownership and management is one distinctive feature of both corporations and sole proprietors. FALSE


22. Shareholders welcome higher short-term profits even when they damage long-term profits. FALSE


23. Investors usually give some companies with good track records the benefit of the doubt when the companies' performance fails to meet the market expectation. TRUE

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: ApplicationDifficulty: MediumLearning Objective: 1-6

24. While control of large public companies in the United States is exercised through the board of directors and pressure from the stock market, in many other countries the stock market is less important and control shifts to major stockholders, typically banks and other companies. TRUE


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25. Insider trading is the purchase or sale of shares based on information that is not available to public investors, and such behavior is accepted by the Securities Exchange Commission. FALSE


Multiple Choice Questions

26. The stockholders in a sole proprietorship are represented by: A. the owner of the firm.B. the general partner of the firm.C. the Board of Directors of the firm.D. no one; sole proprietorships have no stockholders.


27. Which of the following would be considered an advantage of the sole proprietorship form of organization? A. Wide access to capital marketsB. Unlimited liabilityC. A pool of expertiseD. Profits taxed at only one level


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28. In a partnership form of organization, income tax liability, if any, is incurred by: A. the partnership itself.B. the partners individually.C. both the partnership and the partners.D. neither the partnership nor the partners.


29. Which of the following would correctly differentiate general partners from limited partners in a limited partnership? A. General partners have more job experience.B. General partners have an ownership interest.C. General partners are subject to double taxation.D. General partners have unlimited personal liability.


30. One common reason for partnerships to convert to a corporate form of organization is that the partnership: A. faces rapidly growing financing requirements.B. wishes to avoid double taxation of profits.C. has issued all of its allotted shares.D. agreement expires after ten years of use.


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31. Which of the following is least likely to be discussed in the articles of incorporation? A. The maximum number of shares that can be issued.B. The purpose of the business.C. The price range of the shares of stock.D. The number of members of the Board of Directors.


32. When a corporation fails, the maximum that can lost by an investor protected by limited liability is: A. the amount of the initial investment.B. the amount of the profit on the investment.C. the amount necessary to pay the corporation's debts.D. the amount of the investor's personal wealth.


33. Which of the following is not an advantage to incorporating a business? A. Easier access to financial markets.B. Limited liability.C. Becoming a permanent legal entity.D. Profits taxed at the corporate level and the shareholder level.


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34. Unlimited liability is faced by the owners of: A. corporations.B. partnerships and corporations.C. sole proprietorships and partnerships.D. all forms of business organization.


35. Which of the following statements generally cannot be correct for an investor who faces unlimited liability on an investment? A. The investor owns stock in the firm.B. The investor has no partners.C. The investor is subject to double taxation.D. The investor is responsible for managing the firm.


36. In the case of a professional corporation, ________ has/have limited liability. A. only the professionals.B. only the business.C. both the professionals and the business.D. neither the professionals nor the business.


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37. A board of directors is elected as a representative of the corporation's: A. top management.B. stakeholders.C. shareholders.D. customers.


38. The legal "life" of a corporation is: A. coincident with that of its CEO.B. equal to the life of the Board of Directors.C. permanent, as long as shareholders don't change.D. permanent, regardless of current ownership.


39. When the management of a business is conducted by individuals other than the owners, the business is more likely to be a: A. corporation.B. sole proprietorship.C. partnership.D. general partner.


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40. "Double taxation" refers to: A. all partners paying equal taxes on profits.B. corporations paying taxes on both dividends and retained earnings.C. paying taxes on profits at the corporate level and dividends at the personal level.D. the fact that marginal tax rates are doubled for corporations.


41. A corporation is considered to be closely held when: A. only a few shareholders exist.B. the market value of the shares is stable.C. it operates in a small geographic area.D. management also serves as the board of directors.


42. Corporations are referred to as public companies when their: A. shareholders have no tax liability.B. shares are held by the federal or state government.C. stock is widely traded.D. products or services are available to the public.


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43. A common problem for closely held corporations is: A. lack of access to substantial amounts of capital.B. that shareholders receive only one vote each.C. the separation of ownership and management.D. an abundance of agency problems.


44. Corporate managers are expected to make corporate decisions that are in the best interest of: A. top corporate management.B. the corporation's board of directors.C. the corporation's shareholders.D. all corporate employees.


45. Which of the following would not be considered a real asset? A. A corporate bondB. A machineC. A patentD. A factory


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46. Which of the following statements best distinguishes the difference between real and financial assets? A. Real assets have less value than financial assets.B. Real assets are tangible; financial assets are not.C. Financial assets represent claims to income that is generated by real assets.D. Financial assets appreciate in value; real assets depreciate in value.


47. Which of the following would not be considered a financial asset? A. A patentB. A personal IOUC. A checking account balanceD. A share of stock


48. Financial markets are used for trading: A. both real assets and financial assets.B. the goods and services produced by a firm.C. securities, such as shares of IBM.D. the raw materials used in manufacturing.


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49. Corporations that do not issue financial securities such as stock or debt obligations: A. will not be able to increase sales.B. cannot be profitable.C. will not be able to generate sufficient funds to fulfill their needs.D. do not face double taxation of their profits.


50. Which of the following would be considered a capital budgeting decision? A. Planning to issue common stock rather than issuing preferred stockB. A decision to expand into a new line of products, at a cost of $5 millionC. Repurchasing shares of common stockD. Issuing debt in the form of long-term bonds


51. A financial manager facing a capital budgeting decision must decide whether to: A. issue stock or debt securities.B. use the money market or capital market.C. use primary markets or secondary markets.D. buy new machinery or repair the old.


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52. The best criterion for success in a capital budgeting decision would be to: A. minimize the cost of the investment.B. maximize the number of capital budgeting projects.C. maximize the difference between cash inflows and cost.D. finance all capital budgeting projects with debt.


53. The overall goal of capital budgeting projects should be to: A. decrease the firm's reliance upon debt.B. increase the firm's sales.C. increase the firm's outstanding shares of stock.D. increase the wealth of the firm's shareholders.


54. An example of a firm's financing decision would be: A. acquisition of a competitive firm.B. how much to pay for a specific asset.C. the issuance of ten-year versus twenty-year bonds.D. whether or not to increase the price of its products.


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55. Which of the following is NOT a financing decision? A. Should the firm borrow money from a bank or sell bonds?B. Should the firm shut down an unprofitable factory?C. Should the firm buy or lease a new machine that it is committed to acquiring?D. Should the firm issue preferred stock or common stock?


56. Long-term financing arrangements occur in the: A. money markets.B. capital markets.C. secondary markets.D. primary markets.


57. The term "capital structure" refers to: A. the manner in which a firm obtains its long-term sources of funding.B. the length of time needed to repay debt.C. whether the firm invests in capital budgeting projects.D. which specific assets the firm should invest in.


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58. Firms can alter their capital structure by: A. not accepting any capital-budgeting projects.B. investing in nontangible assets.C. issuing stock to repay debt.D. becoming a limited liability company.


59. When a corporation decides to issue long-term debt in order to pay for the acquisition of real assets, it has made a: A. capital budgeting decision.B. financing decision.C. money market decision.D. secondary market decision.


60. A firm decides to pay for a small investment project through a $1 million increase in short-term bank loans. This is best described as an example of a(n): A. financing decision.B. investment decision.C. capital budgeting decision.D. capital market decision.


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61. The short-term decisions of financial managers are comprised of: A. capital structure decisions.B. investment decisions.C. financing decisions.D. both investment and financing decisions.


62. Which of the following represents a financing decision? A. A decision to borrow $10 million through a bank loan.B. A decision to invest in the common stock of another corporation.C. A decision to buy a new mainframe computer.D. A decision to pay $1 million of accounts payable.


63. Which of the firm's financial managers is most likely to be involved with obtaining financing for the firm? A. TreasurerB. ControllerC. Chief Executive OfficerD. Board of Directors


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64. In a large corporation, budget preparation would most likely be conducted by the: A. treasurer.B. controller.C. chief financial officer.D. financial manager.


65. In a firm having both a treasurer and a controller, which of the following would most likely be handled by the controller? A. Internal auditingB. Credit managementC. Banking relationshipsD. Insurance


66. Which of the following statement more accurately describes the controller than the treasurer? A. Likely to be the only financial executive in small firms.B. Monitors capital expenditures to make sure that they are not misappropriated.C. Responsible for investing the firm's spare cash.D. Responsible for arranging any issue of common stock.


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67. A chief financial officer would typically: A. report to the treasurer, but supervise the controller.B. report to the controller, but supervise the treasurer.C. report to both the treasurer and controller.D. supervise both the treasurer and controller.


68. One corporate activity that is specifically reserved for the board of directors is the: A. declaration of dividends.B. custody of records.C. preparation of budgets.D. day-to-day operation of the firm.


69. A financial analyst in a corporation may be involved in: A. proposing a new investment project.B. collecting payments from customers.C. managing investment of the company's cash.D. purchasing the firm's plant and equipment.


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70. Investment banks like Merrill Lynch or Goldman Sachs: A. collect deposits and relend the cash to corporations and individuals.B. help companies sell their securities to investors.C. design and sell insurance policies for businesses.D. lend to corporations and investors in commercial real estate.


71. The primary goal of corporate management should be to: A. maximize the number of shareholders.B. maximize the firm's profit.C. minimize the firm's costs.D. maximize the shareholders' wealth.


72. Within the realm of ethical decision making, managers should attempt to maximize: A. the market value of the shareholders' wealth.B. their compensation plans.C. their firm's market share.D. the profits of the firm.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: UnderstandingDifficulty: MediumLearning Objective: 1-6

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73. Which of the following appears to be the most appropriate goal for corporate management? A. Maximizing market value of the company's shares.B. Maximizing the company's market share.C. Maximizing the current profits of the company.D. Minimizing the company's liabilities.


74. How may a reduction in cash dividends be in the best interests of current shareholders? A. Dividends are taxed at twice the rate of other gains.B. The firm will have available cash to increase current investment and future profits.C. Reduced dividends increase managerial compensation, thus increasing their motivation.D. A reduction of cash dividends cannot be in the best interests of current shareholders.

AACSB: Reflective Thinking SkillsBloom's: UnderstandingDifficulty: HardLearning Objective: 1-5

75. Profit maximization is not a well-defined corporate objective because: A. it leaves open the question of which year's profits.B. higher profits does not necessarily mean a better rate of return.C. profits can be changed by using different accounting rules.D. All of these.


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76. A managerial objective to increase market share is more likely to be successful in the long-run if the firm is: A. selling shares in the secondary market.B. the low-cost producer in the industry.C. managed by the board of directors.D. investing in capital budgeting projects.


77. WorldCom's failure to report $3.8 billion of operating expenses is an example of: A. an effort to conform to changed accounting rules.B. an attempt to maximize the value of the shareholders' investment in the firm.C. an effort to serve the needs of the customer.D. an attempt to increase the company's market value in an unethical way.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: ApplicationDifficulty: EasyLearning Objective: 1-6

78. A first-step in determining managerial objectives is to: A. develop appropriate compensation policies.B. eliminate agency problems.C. serve the needs of the customer.D. select an appropriate capital structure.


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79. Ethical decision-making by management has a payoff for shareholders in terms of: A. improved capital structure.B. enhanced reputation value.C. increased managerial benefits.D. higher dividend payments.


80. Ethical decision making in business: A. reduces the firm's profits.B. requires adherence to implied rules as well as written rules.C. is not in the best interests of shareholders.D. is less important than good capital budgeting decisions.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: UnderstandingDifficulty: HardLearning Objective: 1-6

81. The actions of Salomon Brothers during their 1991 Treasury bond bidding suggest that a firm's reputation: A. cannot be expected to affect profitability.B. is determined by the firm's bondholders.C. is outside of managerial control.D. can impact shareholders' wealth.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: ApplicationDifficulty: MediumLearning Objective: 1-6

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82. In which of the following organizations would it be least likely to find the existence of agency problems? A. A sole proprietorshipB. A partnershipC. A corporationD. A closely held corporation


83. Sole proprietorships resolve the issue of agency problems by: A. avoiding excessive expense accounts.B. discharging those who violate the rules.C. allowing owners to share the cost of their actions with others.D. forcing owners to bear the full cost of their actions.


84. Agency problems can best be characterized as: A. dislike of firm's bondholders by its equity holders.B. differing incentives between managers and owners.C. spending corporate resources.D. friction between the primary and secondary markets.


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85. Which of the following is least likely to represent an agency problem? A. lavish spending on expense accounts.B. plush remodeling of the executive suite.C. excessive investment in "safe" projects.D. executive incentive compensation plans.

AACSB: Reflective Thinking SkillsBloom's: ApplicationDifficulty: HardLearning Objective: 1-7

86. When managers' compensation plans are tied in a meaningful manner to the profits of the firm, agency problems: A. can be reduced.B. will be created.C. are shifted to other stakeholders.D. are eliminated entirely from the firm.


87. The term "corporate stakeholder" typically refers to: A. a company's customers.B. anyone with a financial interest in the firm.C. the equity holders of the firm.D. the management and Board of Directors of the firm.


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88. Which of the following groups is least likely to be considered a stakeholder of the firm? A. GovernmentB. BondholdersC. CompetitorsD. Employees


89. A manager's compensation plan that offers financial incentives for increases in quarterly profitability may create agency problems in that: A. the managers are not motivated by personal gain.B. the board of directors may claim the credit.C. short-term, not long-term profits become the focus.D. investors desire stable profits.

AACSB: Reflective Thinking SkillsBloom's: UnderstandingDifficulty: HardLearning Objective: 1-7

90. One continuing problem with managerial incentive-compensation plans is that: A. the plans increase agency problems.B. managers prefer guaranteed salaries.C. effectiveness of the plans is difficult to evaluate.D. the plans do not reward shareholders.


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91. Which of the following forms of compensation is most likely to align the interests of managers and shareholders? A. A fixed salary.B. A salary that is linked to company profits.C. A salary that is paid partly in the form of the company's shares.D. A salary that is linked to the company's total market value.

AACSB: Reflective Thinking SkillsBloom's: ApplicationDifficulty: HardLearning Objective: 1-7

92. Profit-sharing plans may be beneficial when used to: A. reduce the impact of corporate income taxes.B. improve managers' incentives for effective decision making.C. divert financial resources from shareholders.D. reduce the payment of cash dividends.


93. A corporate board of directors should provide support for the top management team: A. under all circumstances.B. in all decisions related to cash dividends.C. only when the board has confidence in management's actions.D. if shareholders are pleased with the firm's performance.


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94. A corporation's board of directors: A. is selected by and can be removed by management.B. can be voted out of power by the shareholders.C. has a lifetime appointment to the board.D. is selected by a vote of all corporate stakeholders.


95. Options are important instruments in the financial marketplace, and have been traded at least since: A. 1800 B.C.B. 1000 B.C.C. 1929.D. 1972.


96. Which of the following are real assets? I. A patent.II. A share of stock issued by Bank of New York.III. A blast furnace in a steel-making factory.IV. A mortgage loan taken out to help pay for a new home.V. After a successful advertising campaign, potential customers' belief that FedEx will deliver packages promptly and reliably.VI. An IOU ("I owe you") from your brother-in-law. A. I onlyB. III onlyC. I and III onlyD. I, III & V


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Essay Questions

97. What general factors may influence the decision of whether to organize as a sole proprietorship, a partnership, or a corporation?

Factors that may influence the decision concerning organizational form would include: amount of capital needed in relation to amount of capital that can be raised, estimated sales volume, the extent of managerial expertise, the willingness to share profits, the importance of limited liability, a desire for the permanence of the organization, the issue of double taxation.

AACSB: Analytical SkillsBloom's: AnalysisLearning Objective: 1-3

98. Discuss why corporations typically exhibit separation of ownership and management, as distinguished from sole proprietorships or partnerships.

One reason corporations typically exhibit a separation of ownership and management is that ownership often includes a diverse amount of relatively small investors. Thus, it would be nearly impossible to coordinate these owners into decision makers. Also, many small investors are pleased in being relieved of management responsibilities. Therefore, the quality of management is likely to be better if those managers have been hired specifically for that function. Finally, the separation minimizes managerial disruptions that would occur with changing or deceased investors. Most sole proprietorships and partnerships are smaller firms that do not need, may not be able to afford, and may not desire even if they could afford, the existence of a separate management.


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99. Why is limited liability such an important aspect to investors?

Many investors would not be willing to commit their investment funds into projects if it were known they were risking more than those specific funds. Specifically in the case of separated ownership and management, shareholders may be unwilling to remain liable for decisions they did not have a hand in making. With the aversion to risk that is witnessed in general for many investors, it is questionable whether investors would direct their funds into financial assets that did not offer limited liability. Thus, the existence of limited liability may greatly affect the demand for corporate shares.


100. Provide at least three examples each of real and financial assets that might appear on the balance sheet of General Motors.

Examples of real assets for General Motors: cash, raw materials inventory, production facilities, tools and machines, finished inventory of automobiles. Examples of financial assets that could have been issued by General Motors: common stock (different classes), preferred stock, corporate bonds, bank loans, et cetera. Of course, GM could show financial assets on the left side of their balance sheet also, such as: short-term investments in U.S. government securities, contracts receivable from the financing of their automobiles, or possibly residential mortgages (GM, through its subsidiaries, is a large originator of residential mortgages, although most would eventually be sold in the secondary market).

AACSB: Reflective Thinking SkillsBloom's: ApplicationLearning Objective: 1-2

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101. Distinguish between a firm's capital budgeting decision and financing decision.

Examples of the capital budgeting decision for a firm could include: a decision to replace all of the firm's personal computers, a decision to expand the size of the production facility, a decision to buy a corporate jet, a decision to expand production into two new product lines, et cetera. Examples of the financing decision for a firm could include: a decision to issue corporate bonds rather than expand a bank loan, a decision to float a new issue of common stock, a decision to denominate a loan in Japanese yen rather than U.S. dollars, a decision to roll over short-term financing rather than borrow for a longer term, et cetera.

AACSB: Communication AbilitiesBloom's: KnowledgeLearning Objective: 1-1

102. Discuss the interrelationship between a firm's financing and capital structure decisions.

Although the capital budgeting decision considers what to invest in and specifically how much to invest, this decision is importantly related to how the necessary funds should be raised. For example, if many other firms of similar risk have recently issued bonds, the supply of loanable funds may be low, which could affect the interest rate on such funds. Or, the current market value of common stock may be so low that management would prefer not to issue additional shares at this time. Alternatively, the existence of loan or bond covenants could restrict certain forms of borrowing. Finally, although certain forms of financing may appear attractive, they may not represent the targeted capital structure. Thus, elements of the financing decision need to be considered simultaneously with the capital budgeting decision.


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103. Who are the financial managers in large corporations?

The treasurer is responsible for looking after the firm's cash, raising new capital, and maintaining relationships with banks and other investors who hold the firm's securities. Larger corporations usually also have a controller, who prepares the financial statements, manages the firm's internal budgets and accounting, and looks after its tax affairs. Large corporations often appoint a chief financial officer (CFO) to oversee both the treasurer's and the controller's work.

AACSB: Communication AbilitiesBloom's: KnowledgeLearning Objective: 1-4

104. Fritz and Frieda went to business school together 10 years ago. They have just been hired by a midsized corporation that wants to bring in new financial managers. Fritz studied finance, with an emphasis on financial markets and institutions. Frieda majored in accounting and became a CPA 5 years ago. Who is more suited to be treasurer and who controller? Briefly explain.

Fritz would more likely be the treasurer and Frieda the controller. The treasurer raises money from the financial markets and requires a background in financial institutions. The controller requires a background in accounting.


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105. Provide examples of managerial goals other than the maximization of market value.

Managers may attempt to maximize profits, or to maximize market share, or even to maximize their own benefits! Problems with maximizing profits can include the method of maximizing (i.e., is it in the long-run or short-run best interests of the firm?), the maintenance of product quality, ethical decision making, customer satisfaction, et cetera. Problems with market share can include economies of scale (i.e., low average cost of production), maintained profitability, increased liabilities, et cetera. Agency problems that relate to managerial compensation or perquisites that are not in the long-run interest of shareholders are another example of misguided goals.

AACSB: Reflective Thinking SkillsBloom's: UnderstandingLearning Objective: 1-5

106. Are there companies that have attempted to increase their market value in unethical ways recently?

The years 2001 and 2002 revealed an unusual number of bad apples. For example, telecom giant WorldCom admitted that it failed to report $3.8 billion of operating expenses, such that its income became significantly overstated. When the company's true profitability was discovered, it became bankrupt within a month. In late 2001, Enron, the energy trading and investment company, announced over $1.7 billion in losses that had previously been concealed in "special purpose entities" (SPEs). One of Enron's top financial executives allegedly used SPEs to pocket millions at the expense of Enron and its shareholders. Enron also become bankrupt by the end of the year.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: ApplicationLearning Objective: 1-6

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107. Develop a case for the interrelationship of ethical decision making by corporate management and profitability of the firm.

Ethical decision making can have an important impact on employee attitudes, investor actions, and customer retention. Further, all of these factors can have a large impact on the bottom line. The list of potential benefits for a firm that has developed a reputation for ethical operations can be long – easier employee recruitment, lower employee turnover, easier issue of primary securities, repeat business, good word of mouth, et cetera. In other words, the actions of all stakeholders can be positively affected when they perceive the firm to be ethical in its decisions.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: AnalysisLearning Objective: 1-6

108. Is there a conflict between "doing well" and "doing good"? When there are conflicts, how may government regulations or laws tilt the firm toward doing good?

As the text notes, the first step in doing well is doing good by your customers. Businesses cannot prosper for long if they do not provide to their customers the products and services they desire. In addition, reputation effects often make it in the firm's own interest to act ethically toward its business partners and employees since the firm's ability to make deals and to hire skilled labor depends on its reputation for dealing fairly. In some circumstances, when firms have incentives to act in a manner inconsistent with the public interest, taxes or fees can align private and public interests. For example, taxes or fees charged on pollution make it more costly for firms to pollute, thereby affecting the firm's decisions regarding activities that cause pollution. Other "incentives" used by governments to align private interests with public interests include: legislation to provide for worker safety and product, or consumer, safety, building code requirements enforced by local governments, and pollution and gasoline mileage requirements imposed on automobile manufacturers.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: AnalysisLearning Objective: 1-6

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109. Describe agency problems in general, and offer at least three examples from corporations.

Whenever the firm's managers are different from the firm's owners, the potential exists for agency problems. Management may be taking advantage of the fact that corporate ownership is often quite diverse, such that none of the owners appears to be "minding the store." In those cases, it may be easy for top management to vote itself an excessive raise, or to redecorate the corporate suite, or to be lax on the justification of expense reports, or even to invest in projects that are "too safe." Why might managers choose safe projects? For example, the executive may have one year remaining on an employment contract and be more concerned with stable profits than with rising profits.


110. Tabulate and compare the differences among corporations, proprietorships and partnerships.


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111. What are the two major decisions made by financial managers?

Financial management can be broken down into (1) the investment, or capital budgeting, decision and (2) the financing decision. The firm has to decide (1) how much to invest and which real assets to invest in and (2) how to raise the necessary cash.


112. What does "real asset" mean?

Real assets include all assets used in the production or sale of the firms' products or services. Real assets can be tangible (plant and equipment, for example) or intangible (patents or trademarks, for example).


113. Who is the financial manager?

Almost all managers are involved to some degree in investment decisions, but some managers specialize in finance, for example, the treasurer, controller, and CFO.


114. Why does it make sense for corporations to maximize their market value?

Value maximization is the natural financial goal of the firm. Maximizing value maximizes the wealth of the firm's owners, its shareholders. Shareholders can invest or consume that wealth as they wish.


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115. Is value maximization always ethical?

Modern finance does not condone attempts to pump up stock price by unethical means. But there need be no conflict between ethics and value maximization. The surest route to maximum value starts with products and services that satisfy customers. A good reputation with customers, employees, and other stakeholders is also important for the firms' long-run profitability and value.

AACSB: Ethical Understanding & Reasoning AbilitiesBloom's: ApplicationLearning Objective: 1-6

116. How do corporations ensure that managers' and stockholders' interests coincide?

Conflicts of interest between managers and stockholders can lead to agency problems. These problems are kept in check by compensation plans that link the well-being of employees to that of the firm; by monitoring of management by the board of directors, security holders, and creditors; and by the threat of takeover.


117. What actions can shareholders take when the corporation is underperforming and the board of directors is not aggressive in holding managers to task?

If shareholders believe that the corporation is underperforming and the board of directors is not sufficiently aggressive in holding managers to task, they can try to replace the board in the next election. The dissident shareholders will attempt to convince the other shareholders to vote for their slate of candidates to the board. If they succeed, a new board will be elected and it can replace the current management team. Short of that, unhappy shareholders can attempt to elect representatives to the board to make their voices heard. In 2006, for example, dissatisfied shareholders of the H. J. Heinz food company voted in two directors proposed by an outside investor, Nelson Peltz. With over $1 trillion of assets under management, hedge funds have become increasingly aggressive and successful in pursuing this strategy.


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118. What is a Japanese keiretsu, e.g., the Mitsubishi keiretsu? What are the advantages and disadvantages of performing corporate governance in a keiretsu?

In Japan major industrial and financial companies have traditionally been linked together in a group called a keiretsu. For example, the Mitsubishi keiretsu contains 29 core companies including a bank, two insurance companies, an automobile manufacturer, a brewery, and a steel company. Members of the keiretsu are tied together in several ways. First, managers may sit on the boards of directors of other group companies, and a "president's council" of chief executives meets regularly. Second, each company in the group holds shares in many of the other companies. And third, companies generally borrow from the keiretsu's bank or from elsewhere within the group.

These links may have several advantages. Companies can obtain funds from other members of the group without the need to reveal confidential information to the public, and if a member of the group runs into financial heavy weather, its problems can be worked out with other members of the group rather than in the bankruptcy court. The more stable and concentrated shareholder base of large Japanese corporations may make it easier for them to resist pressures for short-term performance and allow them to focus on securing long-term advantage.

But the Japanese system of corporate governance also has its disadvantages, for the lack of market discipline can allow lagging or inefficient corporations to put off painful surgery. As the Japanese economy languished in the 1990s, these disadvantages became more apparent, the links that bound keiretsus together began to weaken, and companies began to sell their shares in other members of the group.


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chapter 001 goals and governance of the firmtestbankcollege.eu/sample/...of-corporate-finance-6th...

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